The S&P 500 is up about 18% from its July lows. The Nasdaq is up 20%.
In a backdrop of declining demand, tighter central bank policy and sticky inflation, how is it that markets have rallied so much following the aggressive selloff back in July?
The market is as much about positioning as it is about fundamentals. Going into the Fed's FOMC meeting in July, the market was positioned extremely bearish with hedge funds having de-geared and wound down not only their net but also their gross exposure.
After the carnage over the summer, it seems the marginal seller dried up. This setup the perfect basis for August, a month that often tends to be a quiet and illogical in terms of liquidity and trends. The slightest of bid can cause a grind higher, which is self perpetuated by all the algorithms getting back in to chase that rally that has no sellers capping it.
Now that retail FOMO traders are very bullish and back invested in the market, the key question here is, will this rally last?
Following second-quarter results, more than 80% of companies that reported actually meet or beat estimates. But the concerns were not as much about the second quarter as they are for the second half of 2022 and more so, next year, given sell-side consensus for margins still seem too high. As is typical of quarterly numbers, they tend to get adjusted lower prior to the event, with results only reporting better than most feared.
The bigger picture has not changed, however. Valuations may be a lot more reasonable now, but companies will have a far tougher time managing their growth and top lines while keeping their costs constant. Margins may have peaked and this presents downside risk to 2023 numbers. Most companies end their buyback blackout period as they report numbers, which also meant a small buyback bid was present in the market in a quiet time like August.
Derivatives play a big role in the large-cap indexes given the amount of open interest that is positioned around key strikes by institutions, pension funds etc. As we head into the key September triple-witching expiry setup, the market is quite long gamma above the key S&P 4300 strike, which means that above 4300 there is a natural tendency for the market makers to sell deltas to be risk neutral.
What is more worrying is that this structure changes in the opposite direction as the market breaks below 4200. The natural tendency for these very same market makers is to sell more deltas on the way down and buy more on the way up -- sort of a non-contrarian move. What ground up slowly in a quiet tape, may just be forced to fall back if the fundamental momentum does not back the move.
The Fed FOMC statement provided a glimmer of dovishness, although it was more that it was not anything incrementally hawkish. The market took that as a pivot point from the Fed and market having passed peak inflation expectations. This was enough to get the shorts to cover and for the market rally to become self-fulfilling.
It is a sad investment environment where investors' justification rests solely on a Fed pivot where they can start printing money again! To call an end to Fed tightening is premature, especially when year-over-year CPI is still averaging closer to 8%. Even with the latest move down in consumer prices, inflation will be nowhere close to the Fed's comfortable 2% range. We are far away from the Fed pausing, let alone embarking on another round of QE.
Since the Fed's MMT experiment decade ago, liquidity has and will continue to be the biggest driving force for risk assets, not valuations. After all, it is all one big macro trade.
